Taxing Inheritances, Taxing Estates James R

University of Michigan Law School University of Michigan Law School Scholarship Repository Articles Faculty Scholarship 2010 Taxing Inheritances, Taxing Estates James R. Hines Jr. University of Michigan Law School, [email protected] Available at: https://repository.law.umich.edu/articles/198 Follow this and additional works at: https://repository.law.umich.edu/articles Part of the Taxation-Federal Estate and Gift ommonC s, and the Tax Law Commons Recommended Citation Hines, James R., Jr. "Taxing Inheritances, Taxing Estates." Tax L. Rev. 63, no. 1 (2010): 189-207. This Article is brought to you for free and open access by the Faculty Scholarship at University of Michigan Law School Scholarship Repository. It has been accepted for inclusion in Articles by an authorized administrator of University of Michigan Law School Scholarship Repository. For more information, please contact [email protected]. Taxing Inheritances, Taxing Estates JAMES R. HINES, JR.* I. INTRODUCTION Just about every living American knows that there is heated political controversy over the taxation of estates and inheritances. The controversy has several sources, prominently including both the absence of a shared concept of tax fairness and a tension between the universal dislike of being taxed and the government's desperate need for revenue. Popular rallying cries and the tax reduction experiments con- ducted by the U.S. Congress and the Bush Administration since 2001 have kept the estate tax on the political front burner,' where it may remain for years to come. How should those who are coolly detached from Washington polit- ics think about the taxation of wealth transfers at death? The recent intriguing proposal by Lily Batchelder 2 to replace the U.S. estate tax with an inheritance tax offers a fresh opportunity to consider the un- derlying justifications for taxing wealth transfers, their implications for tax design, and the likely consequences of reform. In analyzing possible reforms of the estate tax it is critical to bear in mind just what reform might entail, along with any potential alterna- tives. This is particularly important in the context of a reform that seeks to change the distribution of after-tax income, since the government has at its disposal many tax instruments that can and do influ- ence income distribution. Thus, for example, if the goal of tax reform is to reduce the tax burden on low-income taxpayers while increasing the tax burden on high-income taxpayers, a very direct approach would be to increase income tax rates at higher levels of income and reduce tax rates at lower levels of income. The alternative of changing the structure of wealth transfer taxes may achieve some of the same * L. Hart Wright Professor of Law and Richard A. Musgrave Collegiate Professor of Economics, University of Michigan; Research Associate, National Bureau of Economic Research. I thank David Joulfaian, Louis Kaplow, Michael Udell, and various symposium participants for helpful comments on an earlier draft. 1 For assessments of the front burner's estate tax temperature, see Michael J. Graetz & Ian Shapiro, Death by a Thousand Cuts: The Fight over Taxing Inherited Wealth 1 (2005); Edward J. McCaffery & Linda R. Cohen, Shakedown at Gucci Gulch: The New Logic of Collective Action, 84 N.C. L. Rev. 1159 (2006). 2 Lily L. Batchelder, What Should Society Expect from Heirs? The Case for a Compre- hensive Inheritance Tax, 63 Tax L. Rev. 1 (2009). 189 Imaged with the Permission of N.Y.U. Tax Law Review HeinOnline -- 63 Tax L. Rev. 189 2009-2010 190 TAX LAW REVIEW [Vol. 63: purely redistributive objectives, but in a far less direct manner, since estate or inheritance taxes apply only to a small fraction of taxpayers and have an aggregate base that pales in comparison to annual income. Furthermore, any wealth transfer tax reforms that redistribute income among taxpayers are likely to be accompanied by other reforms to income, excise, and other taxes also controlled by the federal government and that also have redistributive effects. One can imag- ine a situation in which a redistributive change in one part of the federal tax system triggers tax changes elsewhere that largely, if not entirely, undo its effect on the distribution of income. A fruitful way to cast the problem of wealth transfer tax design is to ask what role such taxes would play if the rest of the federal tax system were optimally designed.3 Such an exercise serves to identify the potentially unique features of wealth transfer taxes, and their role as a supplement to other revenue sources, particularly income taxes. Real- istically, at least some of the support for existing and proposed federal wealth transfer taxes comes from advocates who are concerned that income is for one reason or another not properly taxed as it is earned. The obvious implication of such concerns is to reform income taxes, but that could be difficult or politically costly in the current environ- ment. Whereas from a reform advocacy standpoint it may then be sensible to call for reforms to that part of the federal tax system be- lieved to be most malleable, from an analytic standpoint it becomes very difficult to understand how one should evaluate the properties of such piecemeal reform directed at problems that stem from other features of the tax system. Hence the most analytically consistent approach is to consider the role of transfer taxes in a system of optimal tax design. Establishing the place of transfer taxes as part of an optimal tax package clarifies extensions to more specific reforms that start from a baseline of inefficient or otherwise suboptimal taxes. One of the many contributions of the Batchelder article is to renew the debate over whether transfer taxes should take the form of obligations of those who give or those who receive. 4 Putting aside minor details of implementation and administration, much of the difference between the two forms of transfer taxation resides in the progressive nature of the tax rate structure. Estate tax obligations are unaffected by how taxable estates are divided among recipients, which is not true of inheritance taxes. A parent with five children of equal incomes 3 For a similar approach to analyzing transfer taxation, see Louis Kaplow, A Framework for Assessing Estate and Gift Taxation, in Rethinking Estate and Gift Taxation 164 [hereinafter Rethinking Estate and Gift Taxation] (William G. Gale, James R. Hines, Jr. & Joel Slemrod eds., 2001); Louis Kaplow, The Theory of Taxation and Public Economics 7 (2008) [hereinafter Theory of Taxation]. 4 Batchelder, note 2, at 6-11. Imaged with the Permission of N.Y.U. Tax Law Review HeinOnline -- 63 Tax L. Rev. 190 2009-2010 2009] TAXING INHERITANCES, TAXING ESTATES 191 facing a progressive inheritance tax minimizes aggregate tax liabilities by dividing the estate equally among the five, whereas the division of the estate would not affect tax liabilities under an estate tax. As an empirical matter, even under estate taxation families generally divide their estates equally among surviving children.5 Hence the much more consequential difference between estate and inheritance taxation is that two families of equal parental wealth but differing numbers of children may face very different aggregate tax liabilities under an inheritance tax. This Article considers two aspects of converting the U.S. transfer tax system to one in which burdens are imposed on the basis of receipt rather than gift. The first aspect is the economic impact of distinguish- ing transfer tax liabilities by numbers of children in a family in addi- tion to the total amount of transferred wealth. The second aspect is the nature of the event that triggers tax liability. Taxing on the basis of receipt raises complicated issues about generation-skipping transfers, transfers to trusts, and transfers that involve foreign as well as domestic parties, all of which are potentially influenced by the logic of taxing on receipt rather than gift. Part II of the Article reviews the logic of wealth transfer taxation in the broader context of the federal tax system. Part III considers the ultimate incidence of wealth transfer taxes, which is to say, the distribution of their burdens, and Part IV analyzes the efficiency costs of taxing wealth transfers. Part V considers the impact of potential reforms on wealth concentration, and Part VI analyzes international aspects of wealth transfer tax reform. Part VII is the conclusion. II. WHAT IS THE SCOPE OF REFORM? It is natural to think of the existing estate and gift tax system as the alternative to any proposed transfer tax reform. The well-known diffi- culty with such a line of reasoning is that the entire existing tax system is imperfect, reflecting, as it does, conflicting interests, political in- fighting and compromises, past and present misunderstandings of economic reality, simple mistakes, perhaps at times even deliberate sabotage-in sum, the many facets of human nature. In such an envi- ronment, the rest of the tax system is likely to be affected if the estate tax were to be replaced with an inheritance tax, since the same com- 5 See, e.g., B. Douglas Bernheim & Sergei Severinov, Bequests as Signals: An Explana- tion for the Equal Division Puzzle, 111 J. Pub. Econ. 733 (2003); Audrey Light & Kathleen McGarry, Why Parents Play Favorites: Explanations for Unequal Bequests, 94 Am. Econ. Rev. 1669 (2004); Kathleen McGarry, Inter Vivos Transfers and Intended Bequests, 73 J. Pub. Econ 321, 322 (1999). Imaged with the Permission of N.Y.U. Tax Law Review HeinOnline -- 63 Tax L. Rev. 191 2009-2010 192 TAX LAW REVIEW [Vol.

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